Investing in the Age of Sovereign Defaults: How to Preserve your Wealth in the Coming Crisis

Appendix A

A Quantitative Approach to Sovereign Risk Assessment

Michael C. S. Wong

Previous chapters consider economic history and economic trends to predict sovereign risk. To monitor and manage sovereign risk exposure, many banks and fund houses mostly rely on mechanical tools to risk rank countries and set their exposure limits. Some simply consider external ratings from different sources and some apply econometric techniques to build shadow models that replicate expert opinions. This appendix will summarize the general practices on modeling sovereign risk and discuss their major weaknesses. Although these institutions have their own models and tools to predict risk, the European sovereign debt crisis in 2009–2012 demonstrates that these models all fail. Sovereign risk assessment can be in the forms of letter grades, ranks, probability of default, high-medium-low, or other ordinal scales. In a broad sense, these outputs on credit risk measurement are the results of some models, which are all about data, variables, procedures, measurements, and methodologies. A model can be an expert model, a scorecard model, a checklist model, a statistical model, or a hybrid one. Will there be any accurate models to predict sovereign risk? Is there any way to improve the model performance? These questions will be addressed in this appendix.

Measuring Sovereign Risk

Sovereign risk does not have a clear-cut definition. Some relate sovereign risk to the inability of a country to fulfill its debt ...